Goldman Isn't Alone in the Delicate Art of Ripping Off People

In his best-selling book The Big Short, Michael Lewis describes a trader named Danny. A Wall Street investment bank came to Danny offering to set up a fancy trade that looked too perfect, too easy. "I appreciate this," Danny told the bank, "but I just want to know one thing: How are you going to f--- me?"

"And the salesman explained how he was going to f--- him," Lewis writes. "And Danny did the trade."

That passage might be the best rebuttal to the letter outgoing Goldman Sachs (NYSE: GS) employee Greg Smith wrote for the New York Times yesterday.

After 12 years with the bank, Smith quit this week, claiming "the interests of the client continue to be sidelined in the way [Goldman] operates and thinks about making money." This is disturbing and, no doubt, true. Smith showed with bravery and honor that he had had enough.

His most damning warning is that if Goldman's culture doesn't change, the firm risks losing clients -- mostly managers of hedge funds, private equities, and mutual funds -- and ultimately going out of business. "I truly believe that this decline in the firm's moral fiber represents the single most serious threat to its long-run survival," Smith wrote.

CNBC host David Faber disagrees, and he makes a strong point stemming from his own experience with dozens of Goldman clients while working on a documentary:

None of them would go on camera. But when you sit down and have dinner with them, they all know this. This is not news to them, that the client doesn't come first. Goldman may say it differently, but it's not news to their clients. The one thing I would take issue with in [Smith's letter] is the idea Goldman will lose clients. Because at this point, they haven't, even though most of the clients I spoke to are fully aware of how Goldman plays them.

They are, in other words, just like Danny -- aware that Goldman is taking advantage of them, but seemingly OK with it.

Asking why is important.

In one sense, they may not have much choice. With Bear Stearns and Lehman Brothers out of business, competition on the street is low. If you want something fancy done, odds are Goldman will be involved, whether you like it or not.

But there's another reason that I think has been lost in this debate. The institutional managers that banks like Goldman call clients can and will make a fortune even after Wall Street's shellacking has been administered. Consider:

After conducting a massive a research project, IBM concluded that global money managers overcharge investors by $300 billion a year for failing to deliver returns above the benchmark. Another $250 billion in fees goes to wealth advisory services that fail to beat stated benchmarks, and $51 billion a year is charged by hedge funds that fail to meet targeted returns.

According to David Norman, former CEO of Credit Suisse Asset Management, UK investors pay 8 billion pounds a year in hidden fees to financial advisors, capturing upwards of one-third of all investor returns.

Fees charged by equity mutual fund managers captured one-third of all investor profits generated by those funds from 2000 to 2010, according to Yoseph West of Vuru. After management fees, two-thirds of actively managed stock funds have underperformed the S&P 500 over the last three years, according to Standard & Poor's. About the same portion have failed over 10-, 15-, and 20-year periods. Most charge fees of 1% to 2% a year for this service.

Last year, SAC Capital Advisors' main fund returned 8% -- barely on par with the Dow Jones. Its boss, Steve Cohen, was paid $600 million, or more than the GDP of six nations.

The average hedge fund charges a hefty 2% management fee (plus a portion of profits), yet average returns have been astonishingly bad. According to author Simon Lack, if all the money ever invested in hedge funds had been invested instead in Treasury bonds, the results would have been twice as good.

You can go on and on all day with stats like these. They tell the same story: The clients that Goldman and the rest of Wall Street rip off are skilled at ripping off their own clients, thank you very much. Each is part of the same game of inflating expectations and overcharging fees -- a system summarized best by the title of Fred Schwed's classic book, Where Are the Customers' Yachts?

And frankly, some of the fees charged by mutual funds and hedge funds are more egregious than anything Goldman can dream of. Which is more obscene: Goldman charging a few percentage points to sell a security, or a money manager taking one-third of the profits that security product generates for his investors? Or worse, still paying himself eight figures when the security blows up and his investors lose their shirts?

That's what bothers me about all of this. What's sad about Goldman abusing its clients is not that its clients lose. It's that Goldman's behavior is merely representative of a system where the clients' clients lose. That's you, the 401(k) investor, the pension fund beneficiary, and the retired schoolteacher. They're the ultimate losers of the Wall Street game in which Goldman is just one example -- and probably not even the worst -- of putting personal interests before clients.

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I would agree with what Jbay said. Is anyone really surprised that large companies like Goldman have their primary focus on maximizing revenue? They are after all in the business of making money and not a non-profit. As regulation increases and their operating costs go up, they will simply pass those costs along to their customers. It's no different if a producer of clothing suddenly sees an uptick in the cost of their raw goods. They will in all likelihood raise their prices.

It is arbitrary to say that "their operating costs go up" due to an increase in regulations. I might feel differently if there were any actual regulations that these companies were forced to abide by. The only costs that go up can be contributed to lobbying to keep regulations from increasing. And @Jbay, are retired school-teachers "playing the game"? as you so eloquently put it. No. The only ones playing are the ones who have nothing to lose. The companies and managers.

I think it's an oversimplification to say that because GS is in the business of making money that this is okay or that they're merely playing the game.

GS could easily continue to make money and be honest with its customers. While it's not a non-profit, that doesn't mean that they are allowed to make money by any means necessary. Gap is a business but they can't steal my wallet while I'm trying on clothes even though they would make more money.

To say that companies play the game and you're either in or out seems to just dodge the question of morality. Sure it may be the case that GS or any other firm has a reputation for being focused on revenue generation but if we just throw our hands up and say 'that's how it is' then we miss the chance to ask if 'how it is' is how it should be.

I don't think Smith is a hero and I was underwhelmed by his letter (which had a poorly designed stream of consciousnesses feel to it) but the questions that other people have raised still seem valid.

<<Gap is a business but they can't steal my wallet while I'm trying on clothes even though they would make more money.>>

True, but in all fairness, that's not what Goldman has engaged in (though it's close to what MF Global did).

A better analogy would be Gap convincing you that you needed to buy gold-plated jeans when the $30 pair would work just fine, and reassuring you that gold jeans will make a good investment while simultaneously shorting gold jeans, and charging you 3% all the while.

I read Mark Dempsky's "ROBBING YOU BLIND" about the churning of securities to generate profits and other schemes. When I called to complain of the poor results of my mutual funds, I was invited to move my business to another branch. Now I'm not even considering mutual funds. I buy only securities and some corporate bonds. Even then I feel that I have been played at some times.

On the other side of the risk coin. How about all the people that advertising convinces to put their money in a bank or tresuries (at times) and get less than inflation. As far as changing the rules. Easier said than done. As gotta said you can always move to another venue.

I dont see need to pay for a summer home or a sports car for these jerks. Research your investment and stop playing "games" to these sleazy CEO's. Jaywalk and spitting sidewalk Will bring you eyeto eye with the authorities.stealing from investors seems to be the "in" thing. In other words,,laws need to be changed to make these sleazy bags accountable. And their cronies, Board of Directors!

I don't quarrel with GS for wanting to earn their pay any more than I quarrel with a doctor or plumber. But the doctor and plumber understand that their clients hire them for their expertise, and treat them with a little more respect. They don't need to ridicule their clients.

The investment world might be full of liars and thieves, but it doesn't have to be. Its in the attitude and willingness to behave correctly.

This is one of the best pieces I've read on this site because it begins to get at something that fundamentally impacts ALL individual retail investors (i.e. the kind that follow the Motley Fool).

In a comment to a recent Housel piece I pointed out that since 1995, annually investing in the SP 500 (dollar cost averaging) produced a return that was equivalent to investing annually in something that yielded 3-5%. I said think of the wealth created by SP 500 corporations over that period and wondered where it all went if the shareholders ended up with only 3-5%.

The answer is the wealth gets siphoned off by the different players in the financial system on its way down to the individual investor (see this article for examples). It doesn't even matter if you don't use financial advisors or mutal funds or hedge funds to do your investing - you're still getting screwed because the companies you invest in pay these guys way more than necessary for the financial services their businesses use. Why don't they care? Because it's not their money they're paying with, it's yours. There is a fundamental disconnect between the shareholders and the companies they own. The result is, as long as management gets paid, it doesn't care where the rest of your money goes, even if it means buying services from people they know are screwing them.

A legitimate capitalist free market would not allow this kind of massive inefficiecy to exist. Competition would, in fact, drive it out. That it hasn't is all you need to know about how efficient and "free" our market really is.

Actually, a better analogy would be if GM deliberately manufactured cars that they knew were designed to crash.

Then they go to some idiot insurance firm large enough that the federal government will have to rescue them when they fail and purchase insurance on every car they sell. They get their marketing team to disguise their true intentions by calling this some kind of value added bundle promotion but nobody bothers to pay any attention to the fact that buried in the fine print GM is the policy beneficiary rather then the customer. To the few customers smart enough to notice and challenge this fact, GM shrewdly points out that they need to be the beneficiary in order to reimburse themselves for the costs of making the next vehicle which will also need to be a GM vehicle under the promotion (though this promise is all verbal, nowhere in writing is a replacement vehicle promised to anybody.)

Over the course of the subsequent three years there are millions of accidents causing millions of car owners to lose their cars, hundreds of thousands of drivers, passengers and pedestrians are injured and maimed and tens of thousand of fatalities occur.

GM ultimately makes far more money on the property and casualty losses then they did selling the vehicles in the first place and before anyone can manage to get to them and successfully litigate against them they bonus out all the profits to their top executives taking themselves to the brink of insolvency and then use their massive employment base of hundreds of thousands of taxpayers to extort the government into bailing them out.

It's a lot easier, speedier and more lucrative to destroy value and bet in that direction then it is to create it and bet that way. All you need is basic entropy for that. Left to its own devices the universe naturally tends toward greater disorder. It actually requires considerable time and effort to arrange the economy's resources in an orderly and productive fashion. That's a lot of work. Why not just take a short cut and bet the other way and tip the scales further in your favor by building financial weapons of mass destruction that only you and a handfully of your closest friends and allies are privy to knowing the appointed hour of detonation thereof?

I find it laugable that the financial services industry is constantly calling things "products" that are actually services. We should hang the industry by its own poor choice of vernacular and apply strict product liability standards to all the financial "products" they create including basic warranties of merchantability. If a firm creates a financial product that achieves no constructive purpose they should be held accountable for that, no just by their customers, but by the authorities. They should not be able to hide behind informed consent any more then GM can if your car explodes with you in it 3 months after you purchased it.

Nothing wrong with making money but remember clients are paying for a service. If that service is not really in the best interest of the client they will eventually move to a better option. Hopefully stories like these will #1 Continue to encourage folks to do their own investing and #2 encourage new firms to take hold and capture this marketplace. At least that is the way it would work if we were truly part of free market economy.

I agree with slpmn "A legitimate capitalist free market would not allow this kind of massive inefficiecy to exist. Competition would, in fact, drive it out. That it hasn't is all you need to know about how efficient and "free" our market really is." The problem is that whenever the market is truly deregulated and free, power and wealth aggregates to a few and the market gets closed again. The medical profession regulates the number of med students, causing MD's pay to be higher than it would be if a free market. Drug lords routinely kill off competition which causes illegal drug prices to be higher, Rockefeller drove out all his competition with pricing, etc. This problem is not unique to Wall Street, its just one more example which is particularly annoying at the present time. Goldman has a sort of monopoly, the nature of which I don't really understand, but the evidence is right there.

Many of Goldman's clients are "trust Fund" kids or "old money" people. All Know that both groups have not a clue about investments and [sometimes] due to in-breeding, will never understand the markets, ie Dupont family, Dodge family. Clients staying with Goldman are clueless.

This is exactly why I handle all my and my mother's investments. I create my own personal mutual fund with quality dividend stocks and pay a flat fee to buy/sell stocks. If I do buy a mutual fund it's one with a management fee less than 1%. I don't trust financial advisers one bit. They're all crooks and all are flipping and advising their "clients" (more like rape victims) to buy whatever provides the most fees to them not what's best for the client.

It may be true that "Goldman isn't alone in the delicate art of ripping people off," but they are alone in the indelicate art.

What has most people upset with Goldman is not their fee structure, but what I would consider their criminal activity.

To quote the American Bar Association Journal:

Goldman sold the mortgage investment, called an Abacus 2007-AC1, and then essentially bet against its success, the New York Times reports. "As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars," the Times says.

Steve Cohen may be a complete dirt bag, but even he isn't knowingly selling his client a hand selected sack of exotic crap and then shorting it behind their backs.

The reason you should avoid hedge funds is because, as the article points out, they historically underperform benchmarks. The reason should not have to be because they are also intentionally tanking your position so they can profit.

The fact that people continue to deal with Goldman in the wake of these findings, is just surreal to me.

The part about hedge fund returns is preposterous. I have probably looked at 1,000 hedge funds and I think have seen fewer than 5 that lag the S&P (inclusive of fees).

However, I agree with the general notion that the best steward of your hard-earned money is yourself if you are willing to put in the time. The fewer parties involved in the allocation of your nest egg, the fewer profit checkpoints your money has to filter through.

If these companies are not adding a real value, then they are legally stealing resources that would go into the overall economy. It really benefits the elitist bankers and drains valuable capital resources. We always talk about accountability and performance. Given the numbers like this, businesses are crazy to play the game with Goldman Sachs or Goldman Steals. If they don't deliver better returns than benchmarks, then they shouldn't be allowed to take a fee. Said another way, they perform or they don't get paid. That sounds fair to me. Please tell me where I am going wrong? 100% of the accountability on the buyer isn't right given the way they control the information and the markets to the detriment of society. If we all make a buck, then everyone would be happy. But they charge outrageous fees, even when they cause you to lose money. They get paid no matter what the performance is, and that doesn't make sense.

My wife funded a 403(b) with Valic who invested in mutual funds. After 13 years what was her annual return? Point 5 per cent. That's one-half of one per cent per year. She could have made a better return if she had invested in returnable beverage containers. Now that we can withdraw the money without a resulting penalty from Big Brother we will do so.

My own approach is to cut the middle-men out of the process by investing in Vanguard market index funds in my retirement account at work and by picking my own stocks and investing through a discount online broker.

I may not beat the market either, but at least I won't be paying management fees to someone else for mediocre performance that I'm fully capable of on my own!